China’s bad banks go rogue

China’s distressed obligations are so intractable that even the government’s own bad-debt specialists are giving up. China Huarong Asset Management Co. and China Cinda Asset Management Co. are instead busy earning their keep in the offshore high-yield corporate bond market.

The two Hong Kong publicly traded asset managers have already raised $8.6 billion issuing notes this year, well on track to exceed 2016’s total of $9.2 billion. The duo’s main mandate is handling the nonperforming loans of China’s state-owned banks. So what are they doing selling dollar debt?

According to Morgan Stanley, it’s about slightly cheaper funding and getting a better match of asset and liability duration.

That’s the politically correct answer. The reality is, over the past 12 months Huarong and Cinda have hardly been doing what they’re supposed to.

At the end of 2016, distressed assets comprised 25 percent and 27 percent of Huarong and Cinda’s total respectively, down from 34 percent and 45 percent two years earlier. Filling the gap has been a multitude of other financial products, such as bonds, that can be traded for a profit.

Restructuring bad debt is tiresome. Yields have been falling as the People’s Bank of China lowers benchmark interest rates, and, according to Huarong Chairman Lai Xiaomin, there’s now a bubble forming as newcomers with little experience investing in distressed debt push up prices at auctions. Real due diligence is required to sort the wheat from the chaff.

Why bother when you can flip debentures instead?

Backed by the Ministry of Finance, Huarong and Cinda are seen as creditworthy borrowers. This spring, the pair issued 10-year dollar bonds that pay a 4.75 percent and 4.4 percent coupon respectively. That’s about 200 basis points over similar maturity U.S. Treasuries. So long as they can buy financial instruments with a better return, they can make money.

Huarong is leading the pack in this regard.

Hong Kong exchange filings would seem to indicate that a large chunk of the proceeds from its April $2.97 billion multi-part bond sale, including $700 million from the 2027 notes, went to its listed Hong Kong unit, Huarong International Financial Holdings Ltd.

In May, just weeks after the offering, Huarong International Financial announced that it had received $800 million in loansfrom its parent. The loans have a weighted average term-to-maturity of approximately 5.6 years. That matches the weighted average maturity of the combined bond tranches.

A similar thing happened in November, when Huarong International Financial got a $500 million advance. Huarong, the parent, sold another $3 billion of bonds that month.

Huarong International Financial is expected to do something for this generosity. It’s been a big buyer of Chinese company high-yield notes, snapping up more than $750 million over the past 12 months alone, exchange filings show. Some pay a coupon as high as 6 percent.

As of June 30, Huarong International Financial’s available-for-sale investments had ballooned to more than HK$10 billion ($1.3 billion), from zero six months ago. Another of Huarong’s listed subsidiaries, Huarong Investment Stock Corp., now has HK$1.4 billion in available-for-sale investments versus HK$925 million at the end of December.

At what point will Beijing wake up to the fact that its bad-loan managers have gone rogue? Perhaps authorities are aware of the situation; we’ll probably never know.

It’s a reasonable bet, however, that some day, Huarong and Cinda will be brought into line and asked to focus on their raison d’etre. Shareholders who have enjoyed stock gains north of 15 percent since January might want to enjoy it while it lasts.